August 21, 2014

Automation Could Speed Trade Finance, But Companies Are Slow to Adopt

The overwhelming majority of global trade is financed either by companies themselves (through trade credit) or by bank-intermediated trade finance, which is estimated by the Bank for International Settlements to support a third of world trade.

Although a nascent technology could speed up how trade is financed, global corporations are not moving rapidly to adopt it.

Letters of Credit and Open Accounts

The most common instrument of trade finance is the letter of credit. In a commercial letter of credit transaction, the seller does not get paid until it provides a detailed group of documents to a bank proving the goods were properly shipped. For example, a $3 million letter of credit provided by JP Morgan in 2013 helped finance the sale of crude barite ore from Mabwe Minerals in Zimbabwe to Baker Hughes Oil Operations in Houston.

The use of letters of credit to reduce the risk of cross-border sales goes as far back as ancient times, say historians. Today, letters of credit finance about 15 percent of global trade. Their value is approximately $1.5 trillion annually, according to the BIS.

But letters of credit are falling out of favor: "excessive complexity and labour-intensiveness, delays in settlement and adverse impact on cash flow and working capital, high rates of discrepancy that negate the protective features of the instrument, and a general sense that these mechanisms are too expensive," were the complaints of corporate users found in a report by Opus and the Society for Worldwide Interbank Financial Telecommunication (SWIFT). By one estimate, up to 70 percent of letters of credit are rejected due to discrepancies or non-compliance.

What's been replacing letters of credit and other traditional trade finance instruments hasn't been a new bank product, however. From a bank's perspective, letters of credit are mostly being replaced bynothing. Instead of letters of credit, exporters have increasingly been extending credit to importers with payment due within 30 to 90 days, known as an "open account" structure. As of 2011, about 80 percent of global trade was financed by trade credit. Banks may still play a role even when companies ship goods on credit by, for example, providing credit insurance.

But there is no doubt that banks have lost trade finance business as companies have increasingly been financing trade by themselves in recent years. As a result, just prior to the financial crisis, banks began to reinsert themselves in international trade. "We must be consultative salespeople," reads a presentation from The Bank of New York Mellon, reflecting that banks view themselves as needing to provide a broader range of risk management and other products to appeal to corporate clients.

Enter the Bank Payment Obligation

Part of the process of banks inserting themselves back into international trade is using automation to get business from companies that would otherwise use open accounts and, to a lesser extent, traditional letters of credit. In 2011, the International Chamber of Commerce and SWIFT joined forces to standardize the rules and processes of the emerging electronic trade finance instrument known as a bank payment obligation (BPO). In 2013, the Chamber adopted uniform rules.

A BPO functions like an electronic letter of credit. Instead of a seller presenting documents to a bank, it sends data showing goods were shipped to the buyer. If the data properly matches, the funds are released. BPOs allow sellers to be paid more quickly by reducing paperwork and the risk that a bank will reject documents. They also increase the speed and certainty of payment relative to trade credit because sellers can rely on automatic data matching and the credit of a bank. BPOs may increase the overall efficiency of trade finance because their underlying technology can be widely adopted by financial institutions using the SWIFT's ISO 20222 messaging standard and Trade Services Utility (or similar application).

As of August 2014, 58 banks, including 18 of the largest 20, had adopted the BPO infrastructure. An increase of nine banks from the prior year. But despite its benefits and adoption by banks, companies have been slow to engage in trade using BPOs. About 35 global companies are set up for BPO transactions.

The main challenges for companies are a lack of awareness and critical mass, and the cost of implementing a new payment system. A particular problem noted by Ray Zarbarte of the Royal Bank of Scotland is that sellers are not being presented with attractive options when it comes to sending BPO data to banks.

To the extent companies have adopted BPOs, it has been to replace letters of credit more than to reduce the risks of selling goods on credit. This is problematic for banks, however, because they view BPOs as a way to introduce themselves into new relationships, not to cannibalize revenues from existing ones.

The lesson from the slow adoption of BPOs is that automation rarely speaks for itself. Even if a new technology promises greater speed, its adoption may nonetheless be sluggish. Banks came at companies with the product, but still have some convincing to do.